International Business Machines Corporation

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now I will turn the meeting over to Ms. Patricia Murphy with IBM. Ma'am, you may begin.

Thank you. This is Patricia Murphy, and I'd like to welcome you to IBM's first quarter 2023 earnings presentation. I'm here today with Arvind Krishna, IBM's Chairman and Chief Executive Officer. and Jim Cavanaugh, IBM Senior Vice President and Chief Financial Officer. We'll post today's prepared remarks on the IBM Investor website within a couple of hours, and a replay will be available by this time tomorrow. To provide additional information to our investors, our presentation includes certain non-GAAP measures. For example, all of our references to revenue growth are at constant currency. We have provided reconciliation charts for these and other non-GAAP measures at the end of the presentation posted to our investor website. Finally, some comments made in this presentation may be considered forward-looking under the Private Securities Litigation Reform Act of 1995. These statements involve factors that could cause our actual results to differ materially. Information about these factors is included in the company's SEC filing. With that, I'll turn the call over to Arvind.

Thank you for joining us. Our first quarter results demonstrate that clients continue to turn to IBM to help them address today's business needs while positioning them for the future. We had a good start to the year with mid-single-digit revenue growth at constant currency in line with our mid-term model and growth in free cash flow. Performance was led by software and consulting as clients continued to accelerate their digital transformations modernize their applications, automate their workflows, and create flexible and secure hybrid cloud environments. More recently, clients are prioritizing digital transformation projects that focus on cost takeout, productivity, and quick returns. While demand for our offerings that support these priorities remain solid, we are seeing some deceleration in consulting from the previous robust growth levels, especially in the United States. Globally, our clients continue to see technology as a fundamental source of competitive advantage. Technology helps them scale and enhance productivity, which is especially important in the face of inflation, demographic shifts, cybersecurity, supply chain issues, and sustainability goals. All of this supports our revenue growth expectations for the year, Our focus remains on revenue growth and free cash flow. Ninety days ago, I shared that in 2023, we'd continue to unlock more productivity, expand our strategic partnerships, and put more investment in specific growth markets. Productivity has always been an important part of our business model. It frees up spending and increases financial flexibility to enable investments. We have started to see some of this payback in our results, which gives us confidence in our ability to achieve our full-year free cash flow objectives. Let me spend a few minutes on the progress we have made in the execution of our strategy. Our focus is on hybrid cloud and artificial intelligence, the two most influential technologies for business. In tandem, these technologies drive both business outcomes and innovations. Hybrid cloud is now the most prominent form of IT architecture, and our approach is platform-centric. Red Hat OpenShift is the leading container platform, enabling clients to leverage the latest innovations in open-source software. IBM software and infrastructure have been tailored for this platform. Our consultants use their technical and business knowledge to speed up clients' digital transformation processes. The first quarter, we co-created with more clients to unlock business value from a hybrid cloud approach. We are working with Virgin Money to migrate their credit card service to the IBM Cloud for financial services. They will also leverage IBM's consulting capabilities to create new digital customer experiences. For the Boston Red Sox, we are collaborating with Wasabi Technologies, leveraging hybrid cloud technologies to analyze key data sources that improve the club's operations. The second element of our strategy is top of mind for a lot of clients, artificial intelligence. AI is projected to add $16 trillion to the global economy by 2030. Keep in mind that AI for business is different than AI for consumers, given their need for more accurate results, trusted data, and governance tools. AI techniques such as foundation models, large language models, and generative AI give businesses the ability to create 100 AI models from a single data set. Early client engagements experience a 70% faster time to value. That is why we are seeing a lot more interest from business in using AI to boost productivity and reduce cost. Productivity gains will come from enterprises turning their workflows into simpler automated processes with AI. To achieve this, we are collaborating with companies like Citi to enhance their internal audit and compliance processes through AI. J.B. Hunt Transport used a Turbonomic AI-powered resourcing and automation engine to optimize their cloud environment. This helped reduce infrastructure refresh costs by 75%. This is a great example of the work we're doing in IT operations. In other areas such as customer care, we are automating hundreds of thousands of call center responses with AI with more than 90% accuracy and greater levels of customer satisfaction. In cybersecurity, our elite defense teams are deploying AI to defend against criminals in real time. In digital labor, We are helping finance, accounting, and HR teams save thousands of hours by automating what used to be labor-intensive data entry tasks. To bring our hybrid cloud and AI strategy to market, our partner ecosystem continues to play a critical role. We expanded our partnership with Adobe to help marketing and creative organizations make the production of content easier. IBM and EY announced a collaboration using IBM software in EY sustainability consulting practice to help companies operationalize decarbonization action plans. Juniper Networks and Nokia also recently expanded their collaboration around IBM's network intelligence and automation solutions to monetize and optimize investments in networks more effectively. We remain focused. on delivering new innovations that matter to our clients. A good example of this is the Cleveland Clinic IBM Discovery Accelerator, where multiple projects are underway that leverage the latest in quantum computing, artificial intelligence, and hybrid cloud to help expedite discoveries in biomedical research. At the Cleveland Clinic, we also recently unveiled the first quantum computer dedicated to healthcare research. To complement our own innovations, in the first quarter we acquired three companies that extend our capabilities in hybrid cloud and AI. We also continue to engage in projects that have a positive impact on society. Many clients are leveraging our technology and expertise to advance their sustainability agendas. For example, in the area of manufacturing, Siemens and IBM are announcing a new software solution that integrates software from both companies to enable sustainable product development. Sustainability is a focus area for all business, and just last week we released our annual report on IBM's efforts in this area, IBM Impact. I'd encourage you to read about our progress in areas ranging from energy savings and carbon emissions reduction to skills development and increasing diversity. I'll conclude by saying that we are confident in the changes we have made to our business over the last three years, aligning our strategy, priorities, and portfolio to the needs of our clients. This work, together with our continued focus on productivity, are enabling us to deliver sustainable revenue and free cash flow growth. I'll now hand it over to James. who will offer more insight into our performance and expectations.

Thanks, Arvind. I'll start with the financial highlights of the first quarter. We delivered $14.3 billion in revenue, $1.4 billion of operating pre-tax income, $1.36 of operating earnings per share, and $1.3 billion of free cash flow. Our revenue for the quarter was up about 4.5% at constant currency. That includes over a point of impact from the businesses we divested. Currency rates impacted our reported revenue growth by four points. That is over $100 million more than spot rates would have suggested 90 days ago. As always, I'll focus my comments on constant currency. Revenue growth this quarter was led by software and consulting. Software revenue was up nearly 6% and consulting up 8%. These are our growth factors and now represent about three quarters of our annual revenue. Our infrastructure revenue was flat with continued strength in Z systems. All three of our geographies grew with high single digit growth in both EMEA and Asia Pacific. Across our business, More than half of IBM's revenue is recurring, led by high-value software, which is growing at mid-single-digit rate. Looking at our profit metrics for the quarter, operating gross margin expanded 80 basis points. We expanded gross margin in all segments, with a strong portfolio mix overall. Operating pre-tax income, excluding the impact of workforce rebalancing, was up 12%. and margin expanded 130 basis points. You'll recall back in January, I mentioned we were planning to address remaining stranded costs from our portfolio actions, and we anticipated a charge of about $300 million. As we executed our plan, we took a charge of $260 million in the first quarter, and we expect to complete this action in the second quarter. This workforce rebalancing charge primarily addresses indirect support functions. We are no longer including workforce rebalancing charges in our measure of segment profit to provide a view of our segment results consistent with our ongoing operational profile. At the IBM level, including the workforce rebalancing activity, operating pre-tax income was down 4%. and margin was down 50 basis points. Within our margin performance, we absorbed a significant currency headwind. The combination of translation and hedging impacted operating pre-tax profit growth by about $160 million and operating PTI margin by 70 basis points year to year. As I've discussed in the past, this essentially impacts our product-based businesses. Mitigating that, the change in useful lives of our server and networking equipment provides a 50 basis point year-to-year benefit to operating PTI margins, which is included primarily in our infrastructure segment. Taking it back up a level, IBM's profit performance this quarter benefits from improvements in business mix and ongoing productivity initiatives. We've been digitally transforming IBM, much in the same way we're helping our clients with their transformation, using both IBM and third-party capabilities. Think of IBM as client zero. We are driving GNA efficiencies by reimagining and transforming the way we work. This includes optimizing our infrastructure and application environments, as well as redesigning our end-to-end business processes. Let me give you a few examples. Across IBM's IT environment, we're realizing the value of hybrid cloud. we reduced the average cost of running an application by 90% by moving from a legacy data center environment to a hybrid cloud environment running on Red Hat OpenShift. We've been simplifying our application environment by standardizing global processes and applying AIOps. We are reducing our application portfolio by more than 35%. We've automated over 24 million transactions with RPA, avoiding hundreds of thousands of manual tasks and eliminating the risk of human error. And we're deploying AI at scale to re-engineer our business processes. We're doing that in areas like HR and talent, finance, and end-to-end processes like quote-to-cash and source-to-pay. For example, in HR, we now handle 94% of our company-wide HR inquiries with our AskHR digital assistant, speeding up the completion of many HR tasks by up to 75%. These productivity initiatives free up spending for reinvestment and contribute to margin expansion. Turning to free cash flow, we generated $1.3 billion in the quarter, This is up $100 million year to year and puts us on track to our full year expectation. Growth is driven by our profit performance and working capital efficiencies, as well as lower payments for structural action. This was mitigated by an increase in capital expenditures and higher performance-based compensation payments given last year's strong results. In terms of cash uses, we return a billion and a half dollars to shareholders in the form of dividends. From a balance sheet perspective, we have a very strong liquidity position with cash over $17 billion, which is up nearly $9 billion from December. We have been opportunistic in accessing the debt market and issued debt early in the year to prudently get ahead of 2023 and 2024 maturities. Our debt balance at the end of the first quarter was over $58 billion, up nearly $8 billion from year end. Turning to the segments, software revenue grew nearly 6% in line with software's mid-single-digit model. We had growth in both hybrid platform and solutions and transaction processing. This performance captures the benefits of our growing recurring revenue stream, which is about 80% of annual software revenue, with continued strong renewal rates. This, together with growth in software transactions this quarter, demonstrates clients' commitment to our hybrid cloud and AI platforms. In hybrid platform and solutions, revenue was up 5%. fueled by growth across all business areas. We continue to see client demand for broad capabilities across Red Hat, automation, data and AI, and security. Red Hat revenue grew 11%, with growth across all major offerings. We have particular strength in our hybrid cloud platform, OpenShift, and Ansible, our IT automation solution. Both offerings also continue to take market share this quarter. Automation revenue was up 2%, driven by integration and application servers, giving client demand for improved IT performance and cost. In data and AI, revenue grew 3%, reflecting growth across data management, business analytics, and asset and supply chain management. Many of these offerings, like DB2, serve as the underpinnings for modern AI and mission-critical workloads. Security revenue is up 2%, with growth across security for hybrid cloud, which includes both identity and threat management and security for data. Bringing this all together, our hybrid platform and solutions ARR is now at $13.5 billion. In transaction processing, revenue grew 6.5%. This software remains core to our clients' hybrid cloud strategies. The strong performance of the last couple Z-system cycles drove significant capacity growth. In fact, install MIPS growth during our Z15 cycle was two times that of Z14. This translates to software opportunity. and contributed to growth in both recurring and transactional revenue. Layering in this year's price increases, we delivered good performance in transaction processing this quarter. Moving to profit for the software segment, gross margin was up and pre-tax margin was flat this quarter, with the latter absorbing nearly a point of impact from currency. Consulting revenue was up 8%, and I'll remind you we had a strong growth in the first quarter of last year. Our book-to-bill ratio over the last 12 months was 1.07. Signings in the quarter grew 7%, with similar performance across both larger and smaller engagements. We continue to see broad demand for projects that deliver technology-driven transformations leveraging a hybrid cloud environment. Within the quarter, demand was solid for cloud modernization offerings, and we had one of our largest Red Hat signings quarters ever. More recently, clients are particularly focused on driving productivity and cost reduction with greater agility and faster time to value. This is contributing to signings growth from digital transformations in areas such as talent, finance, and supply chain transformation. In terms of revenue, while we had solid growth overall, we have seen some clients in the US pull back on more discretionary projects, impacting backlog realization within the quarter. Bringing it back up to the global level, business transformation grew 6%. Technology consulting grew 4%, and application operations grew 13%. Revenue growth was led by data and customer experience transformation projects. In addition, the cloud application development and management. Our hybrid cloud expertise and depth and breadth of strategic partnerships differentiate IBM Consulting in today's markets. Red Hat Consulting revenue, now over $2 billion annually, continued to grow at a double-digit rate. And our strategic partnerships continued strong growth, making up over 35% of our revenue in the segment over the last 12 months. Moving to consulting profit, we expanded both gross and pre-tax margins. Our pre-tax margin of about 8% in the quarter was up 50 basis points year to year, as we continue to benefit from the productivity actions we've taken. Turning to the infrastructure segment, revenue was flat. Hybrid infrastructure revenue was up 4%, and infrastructure support revenue was down 4%. Within hybrid infrastructure, Z-System's revenue was up 11%. This was the fourth quarter of Z16 availability, and the solid program performance has outpaced that of prior cycles. In addition to capabilities around embedded AI at scale, cloud native development for hybrid cloud, and cyber resilient security, clients are also leveraging Z16 for its energy efficiency. For example, consolidating Linux workloads on a single Z16 system can reduce energy consumption by up to 75%. We continue to see strong growth in shipped MIPS for new Linux workloads on Z16. Distributed infrastructure revenue is flat. Growth in storage was offset by declines in power as we have wrapped on the launch of the Power 10 high-end systems. Moving to infrastructure profit, we expanded both gross and pre-tax margins. The 80 basis point improvement in pre-tax margin reflects benefits from both the Z systems product cycle and changes in useful life, partially offset by nearly two points of currency impact. Now let me bring it back up to the IBM level to wrap it up. When we first introduced today's IBM back in October of 2021, we provided a mid-term model for revenue growth, margin expansion, and free cash flow growth. We delivered on that model throughout last year and now have a good start to 2023. In the first quarter, we delivered constant currency revenue growth in line with our mid-single-digit model, expanded gross margin, drove productivity in our underlying business, and grew our free cash flow. Looking at full year 2023, as always, I'll start with our two primary metrics, revenue growth and free cash flow. On the top line, we expect constant currency revenue growth of 3% to 5%. And we continue to expect free cash flow of about $10.5 billion dollars. which is up over a billion dollars year to year. Inherent in our midterm model is margin expansion, driven by improving business mix, efficiency initiatives, and productivity enhancements. Driving efficiency and productivity has always been a part of our operating and financial models. I mentioned some of the initiatives we have underway, and we continue to evaluate additional actions. Altogether, the current initiatives are expected to deliver $2 billion in annual run rate savings by the end of 2024. These initiatives provide additional flexibility, enabling reinvestment in the business to support future growth, contributing to margin expansion, and increasing financial flexibility. Let me spend a minute on our expectations for constant currency revenue and pre-tax profit performance by segment. In software, we continue to expect revenue growth in line with software's mid-single-digit model. This revenue growth drives operating leverage, and we still expect software pre-tax margin to expand by about two points year to year. In consulting, we continue to see strong demand for digital transformations and application modernization. Though, as I said, we are seeing some pressure on more discretionary projects in the United States. We now see consulting revenue growth in the range of 6% to 8% and continue to expect to expand consulting pre-tax margin by at least a point as we capitalize on the yield of our productivity action. Infrastructure revenue is roughly flat over the midterm model horizons. with performance in any year reflecting product cycle dynamics. We're about to wrap on the Z16 introduction. As a result, we expect 2023 infrastructure revenue to decline, with pre-tax margin in the low teens. To provide some perspective, infrastructure should impact IBM's overall revenue growth by over a point. With these segment dynamics, we would expect IBM's operating pre-tax margin to expand by about a half a point year to year. That's in line with our model. And we continue to expect our tax rate to be in the mid to high teens range. As I mentioned earlier, the dollar has strengthened over the last 90 days. We now expect currency translation to be fairly neutral to our revenue growth for the year. which is about a half a point worse than 90 days ago. I'll remind you that our profit and cash dynamics this year are impacted by the unwinding of last year's hedging gains, which is about a point of headwind to our pre-tax margin expansion. Looking at the second quarter, we expect first to second quarter revenue seasonality to be fairly consistent with last year. that's up about $1.3 billion. So the underlying dynamics are different due primarily to Z-Systems product cycle and currency. I'll remind you, we had a successful launch of our Z-16 in the second quarter of last year, and that creates a year-to-year headwind to growth of about three points. In terms of profit, We now expect a little over one-third of our operating net income in the first half, and just under two-thirds in the second half. This reflects a first-half headwind from currency and workforce rebalancing dynamics, both of which flip to a tailwind in the second half. I mentioned the workforce rebalancing activity we have underway. Between the first and second quarter, the charge should be in the range of $300 million, maybe a little more. We still expect this action to pay back by the end of the year. In closing, we entered the year as a more focused business with solid fundamentals. We had a good start to 2023 in our position to deliver revenue growth, expand margin, and grow free cash flow for the year. I'm happy to provide more color on the quarter and our expectations in the Q&A. Patricia, let's get started.

Thank you, Jim. Before we begin the Q&A, I'd like to mention a couple of items. First, supplemental information is provided at the end of the presentation. And second, as always, I'd ask you to refrain from multi-part questions. Operator, let's please open it up for questions.

Thank you. At this time, we'll begin the question and answer session of the conference. To ask a question, please press star one and record your name clearly. If you need to withdraw your question, press star two. Again, to ask a question, please press star one. Our first question will come from Shannon Cross with Credit Suisse. Your line is open.

Thank you very much. Arvind, there's a significant amount of uncertainty with regard to end demand in the marketplace right now. So I'm wondering, as you speak to customers, can you talk to demand trends you're seeing both on a vertical and a geographic basis? Just give us some more color on what you're hearing because, I mean, after CDW, I know it's a different market, but there's a lot of questions out there in terms of what people are spending money on, why they want to spend, and if it's going to continue in the second half. Thank you.

So, Shannon, thank you for the question. And as you can imagine, we spent a lot of time both digesting and making our own estimates based on what our clients are saying. So you said geography, verticals, and then within technology segments. So let me try to unpack it a little. So on a geography level, a lot of the uncertainty that is in the media here, certainly in North America, is not there in Asia at all. If I look across Japan, India, the Middle East, which kind of covers a broad swath of Asia, with the exception of China, we don't see any of that playing out. The geopolitics around China is a slightly different piece, but I think everyone is subject to that right now. Then if I come to Europe, it's actually been stronger than I would have predicted six months ago, but that is because of my point on technology, the deflationary force. When we look at the mixture of interest rates, inflation, wage inflation, demographic, meaning labor shortages, supply chain resiliency, cyber, technology is actually the only answer companies have against all that. Now, that does apply to the larger enterprises who are our primary customers. When I come to the United States, we did see some slowing down in consulting projects, as I said, but that is because consulting is somewhat discretionary. However, we are not seeing people cancel projects. What they are doing is slowing them down, meaning pushing to the right. which is why we took the numbers down for consulting, believing that that may spread in some sense to other parts of the globe as well. Software, we are seeing demand remain very steady. We are not seeing any signs of weakness in software. Admittedly, we are in B2B software. We are not in any B2C segment. And in infrastructure, I think it's less of a macro. It's much more, in our case, a product cycle issue that is playing through. I hope that gave you some color on why we have confidence in the demand, weakness in one particular area, which we think will likely play through. But I want to caution that weakness is not a shrinking. It just says that double-digit rates went down into the 6% to 8%, which is still healthy.

Very good. Thank you for the question, Shannon. Let's go to the next one, please.

Our next question comes from Amit Daryanani with Evercore. You may proceed. Thank you.

Good afternoon. Thanks for taking my question. You know, I was hoping you could talk a bit more on the software side. And I think growth across both hybrid and transaction seems to be fairly good in the quarter. But, you know, Arvind, if you think about some of these consulting softness that's happening, you talked about that in North America. You know, how do you think about the risk of that potentially spreading to some of the software side as well? So I'd love to understand, are you seeing any sense, any of that push out happening in the software side as well? And then as you think about this mixing legit growth in software for the year, how do you think that stacks up between hybrid versus transaction processing? Thank you.

Samit, let me just take the first part of your question on the linkage between consulting and software, and then I'll hand it to Jim for the other parts of the question. So I think that if I look at the consulting, it's not going to spread to software in our belief. Remember, our consulting is comprised, if you just want to break it down into sort of three parts. We work with a lot of other partners, including on the public cloud, including with large software providers, and we tend to do these projects for our clients. I keep cautioning. It's slowing down, but still in the 6% to 8%, not in a rate lower than that. Yes, there is a linkage to software, but a lot of our software is running critical systems for our clients, And we don't see those very subject to what we see in the current macroeconomic environment. And so that's what gives us confidence on those. Also, I think the movement towards hybrid clouds and the ability to take advantage of AI for enterprise productivity is perhaps going to be a tailwind as we enter the second half of the year, because I do think that clients are going to do a lot of automation and a lot of a lot of cost-cutting, which will likely benefit elements of our software portfolio.

Jim? Yeah, so, Ahmed, thank you very much for the question. I mean, as building on what Arvind just said, you know, we are very pleased overall with our start to the year with regards to software here in the first quarter. Nearly 6% growth at the high end of our model overall. By the way, the fundamentals of that business doing extremely well, growing gross margins, 60 basis points growing, pre-tax income, but software is an integral part of not only our hybrid cloud platform thesis, but also an integral part of that economic multiplier equation. You know, $25 billion of revenue, over 40% of IBM's revenue composition, over two-thirds of IBM's profit, solid ARR, $13.5 billion, growing 7%, and a flywheel effect of NRR going well north of 100%. And I think linking back to Shannon's question and part of your question, Arvind's been very clear that we believe that technology is a source of competitive advantage for every industry and every client now. And we built out a portfolio to go capitalize on that. Now, let's take a step back as you asked the question about revenue contribution and then the mix of hybrid platform and solution versus transactional. Let's talk first about the revenue contribution. You know, going back 90 days ago, we laid out the year. We said we were confident in our software portfolio growing on model. We started off the first quarter with putting a dot on the board and contributing to that level actually near the high end. But we said entering the year that we've got about 80% of our portfolio is high value recurring revenue, annuitized revenue. And we thought that that is going to contribute a little over five points of that midterm model growth, mid-single-digit model growth. And underneath that five points, about half of it's going to come out of Red Hat, by the way, growing 11% to 13% for the year, and about half of that out of our recurring revenue stream from IBM, capitalizing on a very strong installed MIPS capacity and renewal rates, along with some price optimization. And by the way, first quarter played out that way. Now, transaction, the remaining 20%, we said we definitely acknowledge we're heading into the down cycle on ELA's. And, oh, by the way, ELA's don't go up 100% one year and down. Over a three-year period, you typically get 60% in the first year, and then it whittles down over the next couple years. And we said we expect about a zero to a one-point headwind. And in the first quarter, we actually did quite well. The transactional volume actually contributed over a point of software's growth. So that's kind of a buildup of the contribution between our two businesses. Now around the lines of business, hybrid platform and solution, our model is anywhere from mid to high single digit. We deliver 5% in the first quarter. And what we see for the full year is right along that model. Red Hat improving given the performance of a renewal cycle. We've got an ARR at $13.5 billion growing 7%. And by the way, that's a leading indicator, which is positive for us. Our cloud pack growth continues to be very strong. And we got new innovation that we continue to bring to market. And then transaction processing, very pleased overall first quarter, 6.5% growth. We believe full year is going to be somewhere in the low range. to mid-single digit. And again, that is capitalizing on that 2X growth in install MIPS and those strong renewal in price. So that kind of hopefully sums up the software portfolio for your question.

Okay, Sheila, let's go to the next question, please.

Our next question comes from Tony Sakonagi with Bernstein. Your line is open.

Yes, thank you. I was just wondering if you could comment a little bit about Red Hat. I think I recall your guidance was for mid-teens growth for the year. And in the first quarter, it was 11% of constant currency, but ex-deferred revenue accounting was probably 7% or 8%. So how do we get confident that the back half of the year where there's little to no deferred revenue accounting contribution can can be fundamentally like 17, 18%. So an acceleration from, you know, seven or eight to 17 or 18. Um, and then secondly, can you, can you comment just on the impact of software pricing? Are you only seeing that in transaction processing or are you seeing it other parts of the software business and, and how should we be thinking about, um, sort of the magnitude of the impact of price increases? Thank you very much.

Tony, great question. So let me start, and then I'm going to give it to Jim for a lot more detail. So first of all, on Red Hat, as I think Jim answered in one of the prior questions and in some of the prepared remarks as well, we are now expecting 11 to 13 percent for the year. That's kind of where we expect Red Hat to be. And that's an all-in number for the year that's inclusive of Q1. So Q1 was at the bottom end of that range. We are seeing more demand coming up as we go through the year. We know our cycles of renewals and Red Hat. If you sort of think that much like other software businesses, it's about a three-year cycle. If you go all the way back to 2020, which was a boom year, those are coming up in 2023. And so we believe that will give us a point or two for the tailwind behind the Q1 numbers. So as we sort of go through that, that gives us confidence based on the demand profile, the renewals, as well as the uptick of the faster-growing areas like both OpenShift and likely answerable coming down the road that we'll see numbers in that range. So with that sort of color on that, let me give it to Jim to add a lot more color onto both Red Hat and the other part on your pricing question.

Yeah, thanks, Arvind. Thanks, Tony, for the question so we can get some clarity out here because I know this has been a hot topic of all of my discussion with investors over the first quarter, especially in light of the macroeconomic environment. First of all, as Arvind indicated, we're pretty pleased with the performance overall of our Red Hat portfolio. Eleven percent growth here in the first quarter off of, by the way, the toughest compare last year at 21 percent growth overall. And by the way, just to put this to rest, the operational growth compared to the gap growth is very similar in the first quarter. So the combination of deferred revenue, which, by the way, is de minimis, it's like in a single million dollars, and the intercompany to get a bridge from operational to GAAP is a rounding error in the first quarter. And by the way, we continue to expect that as we go forward. So the number that we report, and by the way, we're, what, four years into this acquisition now, and we continue to talk about deferred revenue. Well, let's put that aside. Underneath the performance of 11%, Red Hat OpenShift, strong performance here in the quarter, growing north of 40%. We talked about 90 days ago, we put the number out there. Now that we've got to a $1 billion ARR business, we're seeing very good momentum in OpenShift as the leading hybrid cloud platform overall. And our Ansible portfolio, to Arvind's point, is scaling nicely and taking share on top of that. Now, what's going to drive the growth in the second half off that 11%? We called the year now at 11 to 13, I think being prudently cautious. We have a strong renewal available base that will start kicking in in the second half. So I think that's really the core to the answer about the renewal base on the subscription. But Just wrapping up Red Hat and the discussion I have with investors, taking a big step back. We're pleased overall. We're four years into this acquisition. We have quadrupled the Red Hat revenue from pre-acquisition in three and a half years. And around the multiplier effect, we've accelerated our software portfolio significantly. and we've accelerated our consulting portfolio to a mid to high single-digit growth business overall. So we're very pleased overall.

Okay, thanks for that. Sheila, can we please go to the next question?

Yes. Our next question will come from Wamsi Mohan with Bank of America. Your line is open.

Yes, thank you. Arvind, you're now incorporating the possibility for slightly lower revenue growth, sounds like, both around consulting, some areas like Red Hat, and some of this is clearly macro. But at the same time, profitability is even more back-end loaded now. So what is giving you the confidence that these PTI improvements that you're targeting by segment, 100 bps in consulting and 200 bps in marketing, software is really going to come through in the second half of the year, and free cash flow guide remains unchanged despite sort of the revenue outlook having potential deterioration. I'd love to get some color on that. Thank you.

Sure, Ramzi. Look, I'll answer it in terms of what I'm seeing on the business, and I'll let Jim then put some precise numbers on it. We actually, when we spoke to all of you in January – we were saying about a third in the first half and two thirds in the second half. Now we are saying actually a little bit more than a third in the first half and the remaining in the second half. So actually we are actually bringing it up a little bit despite taking on the restructuring charges and some of the Kindle associated charges that we're absorbing in those numbers. So what gives me confidence is when we look at the underlying performance in the first quarter, not all of our actions and productivity play out right in the quarter. But we are seeing enough green shoots in all of them to be able to predict those increases of the point in consulting, the two points in software, et cetera, as we play through the year. And that allows us to have confidence in both the PTI and the cash flow, despite the revenue numbers that we are projecting going forward. And I think actually Q1, is a good down payment towards that, Wamsi. Despite the restructuring charge, we increased free cash flow by $100 million. And so that actually all goes together towards our number. Jim, anything you'd like to add to that?

Yeah, I would just say, I mean, you nailed it, Arvind. Wamsi, thank you very much for the question. Again, another important topic for our investors overall. The real two issues that are driving this distortion of seasonality of our profit and our cash. To Harvin's point, it's currency in the workforce rebalancing charge. We said on the latter that it would pay back in the year, maybe a little bit more, but that is a big distortion of a $300-plus million charge in the first half and a significant return in the second half. And by the way, that will benefit all of our segments. As you know, we fully allocate all of our indirect support costs to all of our segments. So they'll get margin leverage off of that. But the only point I'd make on currency, currency is a very different picture, half to half. Revenue neutral for the year. A headwind, by the way, it was a bigger headwind in the first quarter. It was at the high end of 400 basis points. Second quarter, we say it's about 100 basis points headwind. That turns into a nice tailwind in the second half. And as we talked about many times in the past, currency impacts our business significantly. differently between our human capital-based consulting business, which, by the way, as you all understand, is a natural hedge because cost is sourced the same way as revenue, but our product-based businesses have a distortion in predominantly U.S. dollar cost and revenue in local currency. So when currency flips to a translation benefit in the second half, it has substantial margin leverageability coupled with that software growing at mid-single digit. In a high-value annuitized TP world, that carries very high marginal dollar profitability. So all else equal, currency and workforce rebalancing aside, it's a pretty typical year, and we, on top of that, have put out the $2 billion productivity number that we're going to continue aggressively going after.

Thank you, Wamsi. Let's go to the next question, please.

Our next question comes from Lisa Ellis with Moffitt Nathanson. Your line is open.

Good afternoon. Thanks for taking my question. I wanted to ask about the impact of the recent banking mini crisis we've had over the last six weeks or so. What impact are you seeing on your business given how much work IBM does with financial services firms? Like are you seeing any disruption or maybe on the flip side of that, any acceleration in demand for products and services, say, in like the risk management area? Thank you.

It's a great question. I'll begin by saying that what we have seen, which is so far mostly United States and a little bit in Europe, is going to be a second-order impact on us, not a first-order impact. Let me unpack that and say what I mean. The bulk of the uncertainty is around the smaller banks. They're being labeled regional banks Let me acknowledge some of these regional banks are really national banks. But that said, now as they get forced into tightening some of their lending standards, that is largely going to have an impact on SMB, small and medium business clients who are not our direct clients. Now, let me acknowledge they are clients, though, of other larger companies who are our clients, but it gets muted as in the impact on us. When we're looking at our large banking clients, whether you think of the top five or ten in the United States, you think of the top 20 in Europe, we are seeing pretty consistent demand right now because that is largely driven by payments, by retail accounts, by capital markets. And as you think about all of those, as long as you have reasonable employment and reasonable GDPs, we expect that that demand is going to continue for our first order of clients. The second order will no doubt have a muted, but it's a very tiny impact, and that is kind of what is baked into our current growth assumptions.

Very good. Let's go to the next question, please.

Our next question comes from Eric Woodring with Morgan Stanley. Your line is open.

Hey, good evening, guys. Thank you so much for taking the question. I guess... Arvind, maybe if you can just give us an update on how you're thinking about M&A, just given the broader macro environment, some of the comments you made about the consulting business, interest rates, your cash balance. If you could just bring it all together, maybe just provide an update today, and if anything has changed relative to 90 days ago. Thanks.

Thanks, Eric. Great question. So I actually believe I'll begin by saying I believe that as Asset prices adjust. This could be quite an opportunistic time. Now, is it going to be opportunistic in a month or in three months or in 12 months? I can't really predict. I'll be candid to say most of you probably determine that far more than we do. Now, what are we doing to prepare and in what areas are we interested? If you notice, we carry a fair amount of cash on our balance sheet. As we have pointed out, we have a fair amount of FinFlex assets at the IBM level, even accounting for the dividend. Because if you look at it over a three-year period, that leaves about $20 billion of total FinFlex over three years. We're going to be judicious. We're going to wait for the right time. And it is going to be in the areas that we want. Those areas are going to be in our higher-value software and in areas where consulting can accelerate. We expect to remain 60, maybe 75% of our total spend will be in software. The remaining will be in consulting. In software, we're going to stick to our areas, hybrid cloud, artificial intelligence and data, cyber, automation, the areas we have talked about. So those are the areas. That is the amount we have, and we're going to wait for the appropriate time to leverage. But, Eric, to answer, M&A is a very definite part of our model. And it is part of what is baked into both our mid- and long-term models for growth.

Thank you, Eric. Shil, let's go to the next question.

Our next question will come from David with Stiefel. Your line is open.

Good afternoon. Thank you. You know, Arvind, maybe you could talk a little bit more about, you know, the pricing dynamic in the marketplace and the pricing environment given the shifting macro that we face and And perhaps you can help us better understand how to think of pricing and its impact on revenue growth this year and just prepare us for some of the potential outcomes and pricing and its impact on revenue growth next year. Thanks.

Okay. Thank you, David. Look, I'm going to break my answer up differently between the labor-based businesses and the technology businesses. In a labor-based business, we face the same inflation that the rest of the world is seeing. Our employees are expecting higher wages. As we hire new people, they get hired in at higher wages than their similar colleagues were a year ago. We have to get a return on that back from our clients. That said, if you take a 12- to 18-month period, all of that has to get baked in. Otherwise, that's not a healthy business. But if I take a 6- to 12-month period, there is a slight lag. which is why you get some but not all of that, and you can see that in the consulting margins late last year. We expect that we will begin to get some of that back, but if inflation remains at 10%, then you're kind of behind that, but you get pricing power over the medium term there. If I go to our technology businesses, there is a gain. There is inflation in the goods that we purchase against those, and we invest very heavily in R&D, and in technology, experienced people to help our clients. So there is, again, inflation in there. There is also inflation courtesy currency rates. But it's all in. It's packaged into what I'll use the word inflation. We expect that we will not get the full inflation. If I looked at the number this morning, the U.K. was saying 10%. We will not get 10, but we will get 4 or 5 or 6. So over two or three years, you can feather that inflation back in. which is, again, required. Otherwise, we will not be able to invest in the innovation that our clients want. And that's how you should think about it, that we are willing to sort of feather it in so that our clients don't get a sticker shock right away. But over time, that is, I think, the nature of inflation, if I remember my college economics class.

I would just add one thing. It goes without saying, as Arvind continues to coach me, Pricing optimization is always a direct reflection of the value that you have in the differentiation you have within your offering portfolio overall. So we talked about the consulting side. By the way, fourth consecutive quarter of nice improvement on price margins. You're seeing that play out in the gross margin up 90 basis points. But our software-based portfolio, where we do have differentiation overall, we talked about 90 days ago, right? We had some price optimization, you're seeing some of that play. And in the first quarter, probably about a point. For the full year, we think of our mid-single-digit model might be a couple points. So somewhere in that ballpark, David.

Okay, that's great. Let's take one more question, Sheila.

Thank you. Our last question will come from Kyle McNeely with Jefferies. Your line is open.

Hi, thanks very much for the question. I wonder if you could talk a little bit about your opportunity with AI. You know, whether you're doing anything different with your business now versus the past few years, do you have any new standalone AI products that you're launching that you could use to help re-accelerate in data and AI? I know the products go across the whole business, but some re-acceleration in the data and AI software products would be great. In what areas of the business do you see the most near-term opportunity, whether it's end-to-end applications or foundational models or infrastructure like the VelaCloud native supercomputer you just announced? Thanks.

Kyle, great question. I'm not sure we have an hour, so I'll try to condense my answer into two or three minutes. So we see a lot of opportunities. You used the word foundational models. So I think that, look, just for everybody else, AI has gone through sort of four generations very quickly, from expert systems in the 80s and 90s to machine learning through about 2010, deep learning for the last decade, and now this era of large language models and generative AI. We believe it has a tremendous application to the B2B side of AI inside enterprises. I kind of capture it as AI for business as opposed to AI for consumers. A lot of the excitement out there is on AI for consumers, and I think it's going to be a home run for those companies that are going down that path. But there's a lot of industries that people still worry about the data. They are careful about what's used to train the data. They cannot have an answer that occasionally inserts some fiction into the answer. They need an answer that is from reliable sources only. Then the second part is a lot of these techniques, what people don't realize is it takes down the cost of deploying AI. What we are seeing is that a large language model can be trained and then do 100 tasks with very minor additional training. But yes, the first training is a lot more expensive, maybe four or five times. But then if you can do 100 tasks for almost no additional cost, you can see that the overall is a four to five times benefit in terms of time to value and productivity. So what are some examples? We did a preview of AI for IT ops around a product called Ansible. We're calling it Project Wisdom is our internal code name. But it shows that you can get 60 to 80% of the code that an IT operations person might write gets written by the AI, well, that's a three to four times productivity for that individual. That's one example. Another example that we use, and you can see that play through in our customer care examples, which are multitudinous, whether it's order taking at McDonald's or CVS Health or Bradesco Bank, where we can now do 10 to 15 to 20 languages, as in Spanish, French, English, German, or the cost of effectively one language from the past. But that shows through in the speed of deployment that we can do there. The areas that we are focused on to go drive all this is customer care, IT operations, digital labor, and an example of that is what Jim talked about in our internal service centers, and in cybersecurity. You'll see it come through, sometimes directly like I talked about in wisdom, sometimes embedded with one of our software partners, and sometimes as a piece of one of our products, be it our data lake products or our cybersecurity products. So in all those three flavors, consulting with clients, products from IBM, and products with ISVs. So let me now wrap up the call. I hope what it took away from this discussion over the last hour is we feel very good and confident about our ability to meet client needs in this environment, and our ability to deliver value to shareholders. I look forward to continuing the dialogue as we move through the year. Sheila, I'll turn it over to you to wrap up the call.

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